Should students be allowed sell a fraction of their human capital when they are young to finance the costs of investing in education and going to school? Moshe A. Milevsky explores this and other ideas surrounding the cost and value of an education.

This chapter is from the book

One of my rather bright undergraduate students from a few years ago, who stayed in touch over the years, decided after some years in the labor force to invest (more) in her human capital by returning to graduate school. She wanted to get a master's degree in advanced mathematical finance. I encouraged her to look broadly and consider all the top schools around the world. After a grueling application and admissions process, she was finally accepted to one of the best graduate schools, which happens to be located in the U.S. Midwest. This was quite an achievement for her, and I suspect her acceptance letter has been framed for posterity.

Unfortunately, a few weeks after the good news came in the mail, she got a follow-up letter from the school with the financial details and a huge invoice. She was facing a total cost of almost $80,000 for a graduate education that takes less than two years to complete. (She probably didn't want to frame the invoice.) And although she understood that this was a great investment in her human capital, at the same time, she didn't have $80,000 sitting in a bank account ready to be withdrawn. Furthermore, this was a full-time, intense program that would limit her ability to earn any outside labor income while she was in school. So, like most prospective students, she began investigating various private loans through banks and organizations such as Sallie Mae and government-run student loan programs such as the Federal Direct Loan Program. The paperwork was daunting, the money wasn't free, and she started having some doubts. Was $80,000 in additional debt really worth it? After all, she was still paying off some of her undergraduate student loans.

Investing in a Gold Mine... Called Anastasia

When I found out about the dilemma she was facing—and the possibility she might abandon her educational plans—I offered Anastasia (not her real name, obviously) a deal, which I will outline here. I knew she was a bright and hard-working student who would do extremely well in graduate school and complete the program in the top of her class. My estimate was that she would then go on to a successful career in the financial services industry and likely earn thousands of dollars a year in salary and bonus. In my view, she had the potential of a high-producing gold mine or oil well, and I personally wanted the opportunity to invest in her human capital. So, I offered her $50,000 in cash—to finance the majority of her tuition—in exchange for a mere 10 percent of her pretax earnings during the first ten years after she graduated. To my way of thinking, the money I offered wasn't a loan or any type of debt. It was an investment. As long as she was in school, and wasn't earning any money, she owed nothing. I invited her to think of this as accepting a slightly higher tax rate in the future in exchange for a deeply subsidized education today.

Should We Allow Human Capital Derivatives?

As you saw in the Introduction, "Human Capital: Your Greatest Asset," investing time and money to develop your human capital pays off on average. But the dividends and investment returns—especially given student loan interest payments—might be less than in previous years, as the cost of investing in human capital (getting a college degree) continues to increase faster than inflation (as measured by the consumer price index, or CPI).1 This is especially true for elite private colleges and universities, in which tuition has risen the most and the fastest. College graduates in aggregate have more student loan debt than ever before and are entering the labor force with thousands of dollars in balance sheet liabilities, well before they have taken out their first mortgages.

According to an article in the Wall Street Journal on September 3, 2009, today, almost two thirds of all college students have borrowed money to pay for their tuition; their debt load upon graduation is an average of slightly more than $23,000.

Is there an alternative? I think so.

Here's what I'm thinking: Perhaps there will come a day in the not-too-distant future when current and future students can sell a fraction of their (extraordinarily valuable) human capital when they are young to finance the costs of investing in education and going to school. These young students would get a lump sum of cash in advance or, alternatively, spread out over their years in school. These sums would not be considered a loan, or "bond-like." Rather, the funds would be considered "stock-like"—that is, similar to a company or a small business issuing shares (via an IPO or seasoned equity offering) to finance its expansion and investment opportunities. The money would be repaid by the student, eventually, in the form of preferred dividends for a predetermined period starting after graduation. I'm calling this concept Human Capital DerivativeS (HuCaDS), or, with tongue in cheek, Human Capital Daddy of Sugar.

Here's how I figured the math. When Anastasia graduated in approximately 24 months, I anticipated she would be earning at least six digits—given her previous experience and the typical salary structure for specialists in her field. And, even if her salary remained constant at $100,000 per year (pretax) for the next ten years, that would yield me $10,000 for ten years on an initial investment of $50,000. To analyze this more precisely, I calculated something called the internal rate of return (or IRR) in my Excel spreadsheet program. A cash outflow of 50,000 today followed by zero cash flows for two years (while she is in school) and then by a positive cash flow of $10,000 from years 2 through 12 represents an annualized return of 10.25 percent. That investment return is much better than the rates at my local bank.

In fact, this deal could turn out even better for both of us. Let's imagine that Anastasia performs better than expected, and by her fifth year back in the labor force, she is earning $200,000 per year. So, for the first five years I would receive $10,000 in dividends and for the remaining five years of our HuCaDS agreement, she would be sending me $20,000 each year to pay back my investment. That works out to an internal rate of return—for me—of 15.2%. This is better than you can hope for even in the most irrational of stock market bubbles!

Of course, my HuCaDS arrangement would also leave me exposed to some downside risk as well. Anastasia might decide to shelve her completed master's degree and backpack across Europe or India for five years after graduation, which might satisfy her lifetime ambition to travel the world but would generate zero dividends for me. In that case, her return to the labor force would leave me only five years of cash flows in the contract term. Alternatively, she might decide to join the U.S. Peace Corps—or take a minimum-wage job at McDonalds paying only $25,000. Then the internal rate of return from my $50,000 investment would be zero, or possibly even negative. In those cases, I would have been better off putting the $50,000 under my mattress than investing in a HuCaDS with Anastasia. That is the risk and return trade-off for me: On the upside, I can get returns in the double digits—and on the downside, I could lose it all. Now I obviously would invest only a small fraction of my total net worth in human capital derivative arrangements, but at the same time, I would also derive some psychic dividends from having helped finance a student's education.

I mention this (true) story because I think it could serve as an alternative for future students to onerous and anonymous student loan debt, with potentially crushing interest payments. In my teaching career, I see firsthand how current levels of student loan debt force people into jobs and careers they don't want or like, simply because they have to make the loan payments. My HuCaDS proposal would enable graduates to accept any job they truly want, knowing that they owe only a floating fraction of their salary as opposed to a fixed and unyielding obligation, as with a student loan.